Global markets remain under pressure and one of the reasons is that the world’s number two economy is sputtering. The impact is unlikely to stay within China’s borders. Some of these challenges are own goals, others are deep structural problems while several still reflect a government trying to respond to a changing world.

Locked down

The hard lockdown strategy clearly is an own goal. Other countries have long since abandoned a zero-Covid approach, focusing instead on vaccination. It appears that China’s home-grown vaccines are less effective, while its government has tried to discourage use of imported jabs.

Either way, the damage is clear. Much like in 2020, spending is falling as people are holed up in their homes, while businesses can’t function properly with workers absent and supply chains gummed up.

The economic numbers show the pain: car sales were 48% lower than a year ago in April. The purchasing managers’ index for manufacturing fell to 46 (with 50 being neutral) while the services index was down at 36.

Chart 1: China’s purchasing managers’ indices

Source: Refinitiv Datastream

There is a global impact too since China is still the world’s factory. Container traffic in Shanghai’s port was 20% lower than a year ago, while overall export growth slowed to 3.8% year-on-year in April, indicative of goods getting stuck in ports. Imports were slightly negative from a year ago, reflecting the knock to domestic demand.

Economic growth numbers for the second quarter are likely to show a decline, an unusual event in China. The economy looks set to underperform Beijing’s 5.5% growth target unless there is major stimulus. The International Monetary Fund lowered its 2022 growth forecast for the country to 4.4% percent from 4.8% in January 2022 and 5.6% last October. Even that might be a challenge.

Not stimulating

The problem with a massive stimulus package like the ones Beijing has unleashed previously is that it is unlikely to be very effective while lockdowns are still in place. The economy’s current problem is not that it is starved of credit, but rather it is being prevented from operating at full capacity by government decree. Moreover, a new wave of credit growth risks worsening debt levels that the government had been trying to bring under control. In other words, the short-term imperative of maintaining economic growth is clashing with the long-term aim of debt sustainability.

Nonetheless, there is scope for further interest rate reductions that can ease pressure on borrowers. Inflation in China has been much lower than the US and other developing countries despite being a commodity importer. Consumer inflation was 2.1% in April and when excluding food and fuel it was barely 1%. Producer inflation was 8%, down from a recent peak of 13%. The gap between what producers pay and what consumers pay suggests a massive squeeze on profit margins. Firms have not been able to pass on cost increases, a sign of sluggish demand.

China’s bond market is discounting lower rates and the benchmark 10-year government bond yield has gradually been drifting lower over the past year even as yields in other markets have increased sharply. The US 10-year yield is now above China (2.9% vs 2.8%) for the first time since 2008.

This in turn has resulted in capital outflows that put pressure on China’s currency. The yuan has dropped 6% since the start of the year, an unusual decline for a tightly managed currency.

Regulatory crackdown

While the latest Covid lockdowns are a relatively new phenomenon, Chinese equities have been under pressure for almost two years. Chinese equities initially recovered very quickly from the March 2020 global crash, but soon ran out of steam and today trade almost 20% below pre-Covid levels.

Chart 2: Chinese versus global equities in US dollars

Source: Refinitiv Datastream

A big factor has been tightening of regulations in key sectors as the government aims to level the playing field between big and small players, between companies and customers, and between rich and poor households. The big technology platform businesses like Tencent were particularly hard hit. The government’s repeated crackdowns spooked markets, but one could argue that China is ahead of the West in reining in these firms. Internet technology has developed so quickly in the past decade, regulations have not really kept up. In any event, Beijing has now indicated that it has sufficiently tightened the regulatory screws, but it might be some time before investors trust that the worst is over.

The other big regulatory crackdown still threatens to spiral out of control. Beijing instituted a “three red lines” policy in 2017 to reduce excesses in the heavily indebted property development sector and steer it towards long-term sustainability. However, several of these developers have now gone bankrupt and others are teetering. Activity in the property sector has slowed dramatically and with good reason. Prospective buyers are understandably reluctant to put money down for new properties, worried that the developer might go belly up. Meanwhile, developers are struggling to access funding to finalise existing projects, leading to anxiety among buyers. Property development has played an outsized role in China’s economy over the past two decades and, as a share of total economic activity, is even larger than was the case in the US at the 2006 peak of the housing bubble. As the sector retreats, it is likely to be a substantial drag on overall economic growth.

A fading miracle

Taking a bigger picture view, China’s economic miracle since 1978 has been astounding, but today the economy is very unbalanced. Households earn and spend less than half of Chinese national income, a much smaller share than in most other countries (in SA it is 60%, in the US 70%). Growth was driven by investment spending and exports.

However, the ability to continue taking market share in global exports is limited by the existing size, as well as the increased hostility (trade wars). It will remain important but cannot be a growth driver. As for investment spending, initially the country was so underdeveloped and new roads, bridges, factories, housing developments etc. greatly enhanced productivity. But today much investment spending is unproductive, typified by the infamous “ghost cities”. More investment spending will simply increase debt without enhancing economic returns and the ability to ultimately service the debt. Indeed, President Xi himself recently made the important distinction between “genuine” and “inflated” growth, calling instead for high quality growth. This also indicates that full blown stimulus is unlikely simply for the sake of achieving a growth target.

Meanwhile, the country’s demographic profile continues to worsen. China’s labour force is shrinking because of its now-abandoned one child policy, while the big gains from urbanisation are behind it. This implies that future economic growth will have to come from productivity growth, not from an increasing work force.

South African spill-overs

China matters greatly for South Africa. First and foremost, it is South Africa’s main trading partner depending on how you define it. China is a major consumer of SA commodity exports, while it is also the main source of imports. While energy prices are heavily influenced by the Russian war, industrial commodity prices depend on Chinese demand. While still elevated, industrial metals prices are down almost 20% since the Chinese lockdowns intensified in March. JSE-listed mining shares have lost a similar amount, with more heavily selling last week.

Chart: S&P/GSCI Industrial Metals Index, $

Source: Refinitiv Datastream

Secondly, apart from the commodity impact, South Africa’s financial markets are heavily influenced by global investor sentiment towards emerging markets, which in turn is very sensitive to developments in China. A weak Chinese currency can also translate to rand weakness.

Thirdly, key JSE-listed companies are heavily exposed to China, none more so than Naspers and Prosus who share an underlying investment in Tencent. Tencent is down more than 20% year-to-date, and Naspers and Prosus have lost more than 30%.

Lastly, South Africa tends to lean towards China in international relations. Unlike some other African countries, however, South Africa is not beholden to Chinese influence through borrowing. Should the world one day split into an Amerisphere and a Sinosphere, South Africa would face a tough choice. For now, the world remains deeply integrated and talk of such mutually exclusive blocs remains very premature.

In other words, slower Chinese growth could therefore negatively impact South Africa through several channels. A worst-case scenario is a decline in commodity prices, a fall in the rand, and rising interest rates as was the case in 2015.

How much growth slows in the short term depends on when China relaxes its Covid-zero stance (so far it seems unlikely), how the external environment evolves (including US Federal Reserve policy and the war) and how much Beijing chooses to stimulate the economy.

Uninvestable?

In the longer term, slower economic growth seems the likely outcome. We are used to thinking about China as a 7% to 8% growth economy, but in the coming years 2% to 3% seems a more realistic expectation. However, two things need to be remembered. For an economy as big as China, even 2% to 3% growth represents a large increase in the dollar value of additional production and spending. China will continue to have an enormous impact on global demand.

Secondly, the correlation between GDP growth and equity returns globally is weak. It certainly has been the case in China. Slower growth need not translate into poorer returns since returns have been poor even with rapid growth.

Thirdly, some sectors will grow faster than 2% to 3%, and some sectors slower. Property development will almost certainly lag overall economic growth for a long time, but health, education, finance, and other services will most likely growth faster. These latter sectors still present a long-term opportunity for investors, particularly given how cheap Chinese equities are.

So, is China uninvestable? On the one hand, growth will slow over time and confidence in the government’s management of the economy has taken a big blow. The Rule of Law has never been on par with Western countries (and even South Africa) and certainly the idea that China would eventually become a liberal democracy as its economy develops has gone out the window. However, the opportunities remain significant if investors have sufficient margin of safety for the risks they are taking on in China. This means buying assets at a sufficient discount and only taking on appropriate position sizes. Either way, China is too big to ignore. Even if you directly exclude it from your portfolio, it is still likely to influence your returns. To steal Leon Trotsky’s comment about war: you might not be interested in China, but China is interested in you.

ENDS